Thursday, July 28, 2005

Private/Public Ownership of Natural Monopolies

A natural monopoly is a business that by nature would be impractical to duplicate. A subway system in a major city is a natural monopoly because you could not have two or more competing subway lines running on parallel tracks. The local utilities: gas, water, electricity, are natural monopolies. Even cable television is a natural monopoly. Governments often run these natural monopolies as quasi-independent government corporations. Sometimes these monopolies are owned privately and heavily regulated. In almost all cases, there is an attempt to set the price equal to average cost. Average cost pricing means no profits and therefore the consumer is getting the lowest possible price that can keep the natural monopoly going. Sometimes, the price is set below average cost and the government subsidizes the monopoly directly from tax revenue.

In a recent blog post by Atanu Dey in the new blog The Indian Economy, Atanu argues that the Indian railway service should adopt high-speed trains. He complains that the old trains in India putter along at just 80 kph (55 mph):

The so-labeled “super fast express” trains make their way at a stately 80 kms an hour average, pretty much what they were capable of doing forty years ago. Thirty years ago, the Shinkansens were doing 200 kms an hour and today they exceed 300 kmph. But in India, we maintain a dignified traditional 80 kms an hour for decades on end.

I was reminded of this when I read a recent article in the WaPo about a big subsidy that Congress was considering for the Washington Metro (our subway). The Metro nearly 30 years old and is showing its age. Trains have been derailing recently and the trains run about as fast as the Indian ones. The subsidy comes with strings attached to force this quasi-government corporation (WMATA) that runs the subway to become more accountable:

"We've seen bad management contracting on a fairly regular basis," said Davis, a Republican from Fairfax County who will introduce the bill this morning at a hearing before the House Committee on Government Reform, which he chairs. "These are built-in mechanisms that will make it harder to duplicate the kind of contractual failures that they've had in the last couple of years."

Finally, the bill stipulates that federal money would flow only if the Washington region creates a dedicated source of money for Metro, such as a portion of a sales tax earmarked for transit. That is a significant political challenge to regional leaders and would require the approval of legislatures in Maryland and Virginia as well as the D.C. Council.

"Our federal partners have thrown down the gauntlet," said T. Dana Kauffman, a Fairfax supervisor who chairs the Metro board. He said the lure of federal money might be enough to persuade local and state governments to create a stream of money for Metro. "This may be our best chance in a generation to get stable and reliable funding."

Have they considered raising ticket prices? That would cure the overcrowding problem and the revenue problem simultaneously, and it might reduce the need for additional trains.

However there is a bigger issue that both the Washington Metro and the Indian Railways share: these monopolies exhibit underinvestment. Instead of seeing new technology, we see the old technology persisting, and wearing out. Why is that? Well, if you price your commodity below cost, why would you want to invest more money in the production of it? Profits are the enticement that leads to new investment over time. But you need to be free to raise prices if you want to profit from improved service.

This is the fundamental issue with average cost pricing: the monopoly has no incentive to modernize and to reinvest money in maintaining its infrastructure. If the best you can do is earning zero profit, you can do that with the status quo.

Here is another possibility: suppose the government allows the natural monopoly to be fully private and unregulated but merely becomes a passive owner of a share of that company. Because firms will compete to be the owner of the natural monopoly, they will offer the government a sizable share of the stock in return for majority control of the monopoly. Then the government could earn a source of revenue by being a part owner of a lucrative monopoly.

The most important aspect of this plan is that the monopoly would then have the proper incentive to modernize. Profit would encourage the monopoly to modernize as soon as it becomes economically viable to modernize. And the decision to modernize would be based on sound economics and not on politics. When a politician gambles on a new public investment, he almost cannot lose. When a bureaucrat gambles on a new public investment, he almost cannot win. But when a owner risks his own capital on a new investment, he stands to lose his fortune if he is wrong, and he stands to make a fortune if he is right, so either way, his incentives are proper for him to make the correct decision.

The primary objection to this plan would be that it would probably increase fares substantially and the public would be hurt. Obviously fares would have to rise, but not as much as you might think. These natural monopolies have competition from other sources. A national railroad competes with airplanes and with cars. A subway competes primarily with cars. If the fares go up too much, utilization and revenue will fall. Also, the revenue that the government raises could help the poor, so the argument that the "poor will be hurt by a price increase" is not necessarily true. In any case, everyone will benefit from an investment in new technology if it is economically justifiable to use the new technology.

Another objection is that above cost pricing would be economically inefficient because some people would not ride the trains that could afford to pay the average cost price but cannot pay the monopolist’s price. These transactions would be lost in the economy and this is the classic “deadweight loss.” But we should recognize that this increased price would go partly to fund public services, since the government would be a co-owner of the monopoly. There is a deadweight loss associated with any tax, and this might not be any more inefficient that any other way of raising revenue. The biggest “deadweight loss” is the failure to reinvest in the monopoly. This plan would avoid this failure to reinvest.

Another benefit from privatizing the public monopoly is that other firms will try to buy that monopoly if they think they could run it better. I’m sure there are many corporations that could do a better job of running the Washington Metro than WMATA, but the Metro is not for sale at any price.

25 Comments:

Hi MichaelI think the reason no public transport system in the world has ever made a profit is because they have a lot of routes that are not so well patronized. But, once you privatize the system, wouldnt the company begin to cut down on its less popular routes to stay in business? And this would probably be bad for people (mostly poor who cannot afford to own a car) who have no other means of transport and who depend on these routes for their daily commute? Look at Amtrak, for example.

Hi Gawker:That is an intereting point but I'm not convinced that you need all of these routes covered by rail. In India, it may be that some people really depend on rail. But buses can serve the purpose of transportation by default (the method you use if there is nothing else) and buses are much better for outlying areas because you can use existing roads instead of laying down railroad tracks.

Amtrack is a good example of a rail system that is messed up by subsidy. They should close all of the western lines - they just cannot be justified. The eastern seaboard lines are actually very popular and would pay for themselves easily. I'm for letting a private company buying and running Amtrak as private unsubsidized firm and I'm sure it would be profitable in the East. But if not, no great loss.

Given that India has one of the highest incidences of train accidents, I doubt whether the concept of super fast trains can really take shape.

personally i would like that to happen as people staying in Pune can commute to Mumbai and return back the same day. the cost of such a high speed train network might be high and this might put off some people.

There are lot of ticketless travellers in India and if the authorities try and crack down on these offenders, the coffers will be in good shape.

KapsThat is an interesting point that I made on Atanu Dey's post: uping the speed ups the need for quality control. I think it helps to force a business that does something risky to take out liability insurance for the purpose of motivating them to keep an eye on safety.

The subway in Singapore is fairly nice isn't it? I don't recall riding on it in 1995.

The S'pore subway system is quite efficient. it is popular for its no food / drink / litter policy. however gun toting policemen hv started surfacing and this is causing some panic in the minds of the commuting public.

Govardhan - Thanks for the comments on my post as well as here . As for the abbrasive part, actually it is not. It can be implemented in that way and thus makes it difficult. As I said the price is based on the Marginal Utility for the consumer and not on the Average Cost.

It is a bit tricky and is implemented a bit differently making it a bit skewed.

A very good post. Two things that the Metro accomplishes: the more people that ride on the Metro, lesser the traffic that clogs the beltway and lower the pollution. I have heard these mentioned often in the debates regarding Metro, such as the one that preceded plans to extend the Metro upto Dulles.

If there is an increase in prices and/or routes are cut, the two factors above would have to be ignored.

Hi @mit, Suj, and Half SigmaHalf Sigma: Don't you use the famous New York Subway now that you're there? Surely it could make a profit.

Suj:The best way to get people to ride the Metro is the expand the lines - and improve the speed. They are thinking of adding lines but no speed increase in sight (which is just as well since the trains are derailing as it is). A profit making firm will soon figure out that the real money is in adding more regular paying customers.

Privitization certainly has its benefits and for me the biggest benefit would be an increase in efficiency - not economic as Half sigma suggests - but energetic efficiency. This would happen only when the market is regulated i.e. controlled prices, while having a different take on subsidizing. Take for instance the petroleum industry in India (I understand that it is not a natural monpoly).

At the same time, privatization can lead to a lot of difficulties for citizens without it being regulated. As Greg Palast points out in his book 'Best Democracy Money Can Buy', whereever utility companies have been privatized the customer has had to pay 200-300% more than before. Particularly true in the case for South American 'democracies'. The recent demostrations in Bolivia as an example of this.

I would also like to emphasize suj's point regarding subways or any public transport system - low cost must be ensured to drive more people to use them. The world can do with fewer cars on the streets. At the same time, if the public transportation is not energy efficient - this argument will have not much to it.

Thus I feel, regulated privatization with a new take on subsidies is the way to go.

The USPS is a corporation too. It has more aims than making money as does any government. The Indian Railways also is exactly like the USPS. The aim is not to make profits but provide efficient and useful service affordable to people in a country that has per capita income less than that of Zimbabwe. To have super duper fast trains that will need air-condition and more fuel (because of the heat and dust generated in the Indian environment) and not adding the cost of buying and deploying new such trains, might fill US-returned/expatriate Indians with pride but who will pay the fares?

Like the USPS, the Indian Railways has a wider social purpose and can be run efficiently. Moreover, there is not much evidence that utlities taken over the by the private sector show any more efficiency.

For country as poor as India, the Indian Railways are run well. For the railways to improve, India will have to raise its income.

India has the highest incidence of rail accidents because it has the largest and mostly widely used network in the world. Compare India's railway to the road/car system in the US. Many Americans justify deaths by comparing them to road accident deaths.

America has built roads in the nooks and corners and India has rails in nooks and corners. Different countries having different strategies to serve their people.